Since early 2020, the news cycle, both globally and at home, has been dominated by the COVID-19 pandemic. In an attempt to limit the spread of COVID-19, governments have placed substantial restrictions on the activities of individuals and businesses. For the majority of businesses this has resulted in substantial operational and financial impacts. Many of those businesses that report under International Financial Reporting Standards will also find that COVID-19 has substantial financial reporting impacts.

The types and extent of impact that COVID-19 will have on an entity’s financial statements is largely dependent on two factors:

The transactions that the entity enters into and the assets and liabilities that it holds, and

The entity’s reporting date.

In our March 2020 edition of Accounting News, we examined the financial reporting impacts of COVID-19 on entities with 31 December 2019 annual and interim reporting dates, and noted that in many cases, the significance of any impacts would be disclosed in the financial statements as a non-adjusting event after the reporting date because the World Health Organisation only declared COVID-19 a global health emergency on 30 January 2020.

In this edition, we look at COVID-19 impacts on the impairment of other assets, as well as impacts on the measurement of other items, including provisions and insurance recoveries.

Impairment of non-financial assets (IAS 36 Impairment of Assets)

The impairment requirements in IAS 36 apply to the following types of assets:

Goodwill

Intangible assets

Property, plant and equipment

Right-of-use assets

Associates and joint ventures accounted for using the equity method

Investment properties measured using the cost model

Cost to obtain or fulfil a contract recognised under IFRS 15 Revenue from Contracts with Customers.

When should assets be tested for impairment?

IAS 36 requires goodwill, intangible assets with an indefinite useful life, and intangible assets that are not yet available for use, to be tested for impairment annually (regardless of whether there are impairment indicators), or more frequently if events or changes in circumstances indicate that they might be impaired.

Other non-financial assets listed above must be assessed for indicators of impairment at each reporting date. Where indicators of impairment exist, the asset must then be tested for impairment. Indicators of impairment can include factors internal to an entity, such as damage to the item, and factors external to the entity, such as changes in expected future technology and changes in economic conditions.

Given the substantial economic downturn that is predicted as the world emerges from the immediate impacts of the COVID-19 pandemic, it is likely that impairment indicators will exist for a substantial numbers of assets, which could result in significant impairment write-downs in financial statements with reporting periods ending from 31 January 2020 onwards.

At what level should assets be tested for impairment?

Individual assets are tested for impairment (e.g. a single item of PPE such as a motor vehicle) unless the asset does not generate cash flows that are largely independent of cash flows generated from other assets or groups of assets. Practically this means that many assets will be grouped into cash-generating units (CGUs) for impairment testing, with CGUs being identified at the lowest levels for which there are separately identifiable cash flows.

How are impairment losses determined?

An asset or CGU is impaired if its carrying amount exceeds its recoverable amount. The recoverable amount is the higher of an asset’s fair value less costs of disposal (FVLCD) and value in use (VIU). Impairment losses are recognised in profit or loss.

Value in use (VIU) - Assumptions

VIU is determined by estimating future cash flows from the use and ultimate disposal of the asset, and discounting these to their present value using a pre-tax discount rate that reflects current market rates and the risks specific to the asset.

The discount rate does not reflect risks for which future cash flows have already been adjusted because this would result in the risks being ‘double counted’. This means that when calculating VIU for a CGU, the entity will either apply risk adjustments to:

The cash flows (for example by assigning probability weightings to various possible cash flow scenarios), or

The discount rate.

When determining VIU, it is important that the estimates of future cash flows are realistic. Ordinarily, past performance is likely to be a useful starting point for the estimation of projected future cash flows. However, in the current environment, models of the future will need to incorporate unprecedented shocks, as decreases in asset values, decline in demand for goods and services and supply chain disruptions may be dissimilar to any previously encountered scenario. This will make forecasting particularly difficult, which may mean that additional disclosure of the key judgements made and estimates used may be required.

Can we use hindsight when making assumptions to determine VIU?

Most governments had mandated social distancing rules and varying degrees of ‘lock down’ by the end of March 2020, so these actions will be factored into cash flow forecasts for impairment models for entities with 31 March 2020 reporting dates. However, the requirement not to use hindsight in impairment models may be more difficult to implement for entities with January or February 2020 reporting dates, because information regarding the effects of COVID-19 was changing rapidly and governments took actions at different times. Therefore, deciding whether information subsequent to reporting date relates to conditions that existed at reporting date (and therefore should be built into impairment models), or whether it relates to post balance date events is not straight-forward. Our latest IFRB - Impairment implications of COVID-19 discusses this concept in more detail.

Right-of-use assets (lessees)

Businesses (lessees) that have received rent concessions from landlords need to consider whether this is an indicator of impairment at reporting date, and if so, either test the ROU asset for impairment individually (usually only possible where the ROU asset generates independent cash flows, such as via a sub-lease), or as part of a CGU.

IFRS 16 may also result in the recognition of more corporate ROU assets, e.g. leased corporate head office, which must be allocated appropriately to CGUs for impairment testing purposes. Please read our article, How to amend impairment models for right-of-use assets under IFRS 16 below for more information about how VIU calculations will change when CGUs include ROU assets.

Using FVLCD as recoverable amount

Due to the implications of COVID-19 on global asset prices, availability of capital and risk appetites of market participants, the price an entity would receive at say 30 June 2020 for an asset may be significantly lower than prices or estimates of prices it may have received at previous dates. Therefore these ‘COVID-19 decreases’ may appear to be a ‘distress sale’ requiring adjustment in the fair value estimation. However, other than in extreme cases, such decreases in value should not be adjusted for a lack of current information or declines in trading. Significant decrease in prices at one point in time are a consequence of fair value measurement, which is a current amount as at the period end. Similarly, the fact that there may have been a significant reduction in trading volumes for a particular asset listed on a public market does not mean that it is appropriate to disregard the ‘Level 1’ quoted price.

Due to difficulties in determining FVLCD, it is therefore more practical for entities, where possible, to use VIU as recoverable amount.

It is also worth noting that FVLCD estimates carried out using a discounted cash flow model are likely to incorporate significant unobservable inputs (Level 3) which require specific disclosures.

Inventories

COVID-19 could result in entities carrying more than usual inventories due to shut down of business and the carrying amounts of inventories being overstated for two reasons:

Allocation of excess fixed production overheads, and

Net realisable value being too high.

Subsequent to initial recognition at cost, IAS 2 Inventories requires inventory to be carried at the lower of cost and net realisable value. The cost of inventories is the sum of the costs of purchase, ‘costs of conversion’, and other costs incurred in bringing the inventories to their present location and condition.

The ‘costs of conversion’ include costs directly related to the units of production, such as direct labour, and a systematic allocation of the fixed and variable production overheads that are incurred in converting materials into finished goods.

Allocation of fixed production overheads

The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of low production or idle plant – rather, unallocated overheads are recognised as an expense in the period in which they are incurred.

Where production has decreased during this COVID-19 period (for example, due to a decrease in demand or a government requirement for all non-essential businesses to cease operations for a specified timeframe), the portion of fixed overheads that would have been allocated to inventory must instead be expensed.

Example

Assume that a factory has $1,200,000 of fixed costs and that normal capacity is 10,000 units per month. This means that $10 ($1,200,000 / [12 x 10,000]) of fixed production overheads is allocated to each unit of inventory.

In a month in which the factory operates to normal capacity, $100,000 ($10/unit x 10,000 units) of fixed overheads would be allocated to inventory. However, if that factory only produces 5,000 units in that month, due to reduced demand, $50,000 ($10/unit x 5,000 units) would be allocated to inventory and the remaining $50,000 would be expensed as follows:

Dr($)

Cr($)

Inventory (fixed production overheads)

50,000

Fixed production overheads – P/L

50,000

Cash

100,000

If the factory was shut down by government for a month and did not produce any inventory, the entire $100,000 of fixed overheads would be expensed.

Net realisable value

The carrying value of inventory may also be impacted if there is a need to reduce sale price due to decreased demand (brought about by government-mandated lockdown periods or increased economic uncertainty). If sale price decreases, and that price reduction will not just be for a limited period, net realisable value (which is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale) will also fall. When that occurs, net realisable value may fall below cost, triggering a requirement to write inventory down to net realisable value.

Finally, if inventory has a short shelf life, or is prone to rapid obsolescence, decreased sales may result in stock needing to be written off completely.

Exploration and evaluation assets

IFRS 6 Exploration for and Evaluation of Mineral Resources allows entities the option of either capitalising, or expensing, costs related to exploration and evaluation activities. Where such costs are capitalised to exploration and evaluation assets, the assets must be assessed for indicators of impairment and, if such indicators exist, tested for impairment, in accordance with the requirements of IAS 36 (as outlined above).

COVID-19 has substantially reduced global economic output, which has led to substantial reductions in global commodity prices. This fall in commodity prices will likely reduce the recoverable amount of exploration and evaluation assets, leading to the need to recognise impairment on such assets.

Investments in associates and joint ventures

IAS 28 Investments in Associates and Joint Ventures requires investments in associates and joint ventures to be accounted for by equity accounting.

Before applying the equity method, an entity must recognise expected credit losses in accordance with IFRS 9 Financial Instruments if an investment in an associate or joint venture includes a long-term interest that is subject to impairment assessment using the expected credit loss model (such as a loan to the investee).

The equity method is then applied, by recognising the entity’s share of the profit or loss of the investee as a single line item in profit or loss and as an adjustment to the carrying amount of the investment in the statement of financial position.

After that has been done, the remaining carrying value of the investment must still be assessed for indicators of impairment (and, if such indicators exist, tested for impairment) in accordance with the requirements of IAS 36, as outlined above.

If the carrying value of an interest in an associate or joint venture is reduced to zero, any additional losses and an associated liability must be recognised if the investor has a legal or constructive obligation to make payments on behalf of the associate or joint venture.

COVID-19 may result in a reduction in the carrying value of investments in associates and joint ventures due to sustained losses incurred by these entities.

Deferred tax assets

Like all assets, deferred tax assets can only be recognised when their recovery is probable.

In assessing the likelihood of recovery of deductible temporary differences, an entity must develop forecasts that consider all available information. Given the level of economic damage already caused by COVID-19, and the uncertainty now surrounding the future, forecasts may need to be based on extremely pessimistic forecasts. Even if tax losses and other deductible temporary differences have no fixed expiry, or a very long-term expiry, it is not appropriate to assume that, in the long term, the business environment will return to normal and that consequently deferred tax assets should be recognised.

In many ways, the assessment of whether deferred tax assets meet the requirements for recognition mirrors the assessment of whether an entity remains a going concern, as both assessments will be dependent on the same forecasts. For that reason, where there is a material uncertainty related to going concern, there will almost certainly be no basis for recognising a deferred tax asset.

Provisions

Contracts to purchase supplies or provide goods or services that were commercially viable prior to COVID-19 may not be commercially viable now. Where the unavoidable costs of a contract exceed the economic benefits to be derived from the contract, the contract is onerous and a provision will need to be recognised.

When recognising a provision, the amount to be recognised requires considerable judgement, as it must be the cost of the least expensive available option. Where the contract is for an extended time period, discounting may also be required.

Example

Assume an entity that makes apple sauces, apple pies and other apple-based desserts for high end restaurants:

Has a balance date of 31 March 2020

Usually uses 15,000kg of apples per month

Secured a contract in late December to purchase apples at $1.00/kg, with a requirement that it purchase a minimum of 10,000kg of apples per month from January to June 2020

Met the minimum purchase requirements in January, February and March 2020

Forecasts a reduction in sales (due to a number of factors, including government-imposed lockdowns of restaurants and an economic downturn) that will mean that it only needs 5,000kg of apples for April, May and June 2020.

The entity is unable to store its apples and use them at a later date because the restaurants that it supplies have very strict quality and freshness requirements. However, the entity has been approached by a maker of apple cider that is willing to buy the entity’s excess apples for $0.20/kg and will pay the associated delivery costs itself. If the entity takes the apples and can’t find a use for them, it will be forced to pay $0.05/kg to dump them.

This means that there are three options available to the entity in relation to its excess apples:

Do not take the apples from the supplier – the cost for this will be $1.00/kg, which means that the total cost over three months will be $15,000 (3 months x 5,000kg/month x $1.00/kg)

Take the apples from the supplier and then dump them – the cost for this will be $1.05/kg, which means that the total cost will be $15,750 (3 months x 5,000kg/month x $1.05/kg)

Take the apples from the supplier and on-sell them to the apple cider manufacturer – the cost for this will be $0.80/kg (cost of $1.00/kg – sales price of $0.20/kg), which means that the total cost will be $12,000 (3 months x 5,000kg/month x $0.80/kg).

The lowest cost option is to on sell the excess apples to the apple cider manufacturer. This means that, at its 31 March 2020 reporting date, the entity should recognise a provision for an onerous contract of $12,000.

Insurance proceeds

Where an entity is able to claim on insurance in relation to the impacts it has suffered as a result of COVID-19, it is important to remember that recognition of those insurance proceeds can only occur when the entity is virtually certain to receive them. This is often only once the claim has been accepted by the insurer and the insurer has communicated the amount that will be paid. From a practical perspective, this means that insurance proceeds are usually recognised when received. However, where the insurer communicates the amount to be paid close to the reporting date, but has not made the payment by that date, the proceeds should be recognised at the point when the amount to be paid was communicated.